Pandora Plays Nice As Apple's iTunes Radio Spins Up

Music publishers, record labels, civil rights groups and even members of Pink Floyd have spent the past year piling on Internet radio service
Pandora Media. They've called its founder, Tim Westergren, a robber baron. They have accused Pandora of making millions off musicians' work. They claim it's trying to slash artists' pay through legislative maneuverings over royalties.

Chalk it up to the perils of pioneering. In eight years Pandora has moved to the top of the Internet radio charts, with 71 million monthly active users. It accounts for 70% of Internet radio and 8% of total U.S. radio listening. Advertising, which accounts for 80% of revenue, will hit $643 million this year. Mobile ad sales topped $100 million for the first time in the third quarter of 2013, making Pandora third in mobile ad revenue behind only
Google and
Facebook. Shares of the Oakland, Calif. firm have nearly tripled in the past year as investors realized its market position.

But Pandora is renegotiating (likely downward) its royalty rates with artists, labels and music publishers.

That put Tim Westergren and Pandora's new CEO, Brian McAndrews, in the middle of a public relations mess just as they're facing what may be their biggest existential threat: Apple's new iTunes Radio, a service similar to what Pandora offers. Westergren admits there have been "misunderstandings" about Pandora's royalty moves but says it's just trying to balance a system that's forcing it to carry an "unfair" and "high royalty burden." Proof point: Pandora has yet to turn a profit, and it's expected to continue to rack up losses.

"In spite of all the rhetoric, Pandora supports very healthy royalties for artists," says Westergren, who worked as a struggling musician before turning Internet entrepreneur. "We're going to play music by artists that have never been played on radio before--and play it to a wide enough audience that we'll create a musician's middle class."

The warm-and-fuzzy message has been adopted as well by McAndrews, who came over after a stint running Microsoft's advertising and publishing service: "Musicians should be fairly compensated for their art."

Pandora does have a point when it talks about the complicated U.S. music royalty system: Internet services pay higher royalties than cable and satellite radio, while AM/FM radio doesn't pay a cent to performers. Last year Pandora paid out about 56% of its $427 million in revenue in performance royalties while rival satellite service Sirius XM paid out 8% of sales.

Pandora's p.r. problem stems from its support of the Internet Radio Fairness Act of 2012, which many view as a betrayal, intended to benefit the company at artists' expense. IRFA requires the Copyright Royalty Board, which sets performance royalty rates, to use the same standard across music services. That would effectively lower Pandora's payout, though Westergren has never said by how much. Even so, music rights holders would love to see the system changed because they believe it short-changes them.

"We want Pandora to succeed," says Ted Kalo, executive director of the musicFIRST Coalition, which persuaded 138 bands and artists to oppose the bill (which quickly died in committee). "But there's a fundamental compact between these services and the people who create music. Our musicians want to receive a fair day's pay for a fair day's work. But by running to Congress to get their own deal, [Pandora has] run away from that compact."

Former members of Pink Floyd were more blunt, citing "Pandora's Internet radio royalty ripoff" in a USA Today op-ed. "A business that exists to deliver music can't really complain that its biggest cost is music," wrote Roger Waters, David Gilmour and Nick Mason.

Now, a year after endorsing IRFA, Pandora has shifted focus away from the bill, a pragmatic move given it was unlikely to get passed in this largely dysfunctional Congress bogged down by Obama?Care and the budget. "Pandora will focus on other paths to resolution" and keep fighting against a system that "prevents fair competition in the marketplace," Westergren says.

That other path includes negotiations over performance royalties with the CRB. Talks begin in January to decide rates from 2016 to 2020. With IRFA off the table, Pandora might be able to wrest more favorable terms from the CRB. Why? Apple reportedly negotiated its own deals directly with labels--and Pandora believes Apple's payout is less than what it pays. If true, Pandora could use Apple as precedent for fair compensation.

Apple hasn't disclosed its fee, but there's speculation it pays labels $0.0013 each time a song is played, plus a cut of ad revenue. That seems higher than Pandora's $0.0012 per song except for one thing: Apple reportedly doesn't pay for every song that is played for less than 20 seconds. Pandora says it pays even for just one second of play. How much does Pandora pay for songs played for less than 20 seconds? Former Pandora CEO Joe Kennedy, who retired this year, says it's "material."

Plenty of musicians appreciate Pandora for what it is: a way to promote songs listeners want to hear, rather than favoring major artists. Patrick Laird of the instrumental cello rock group Break of Reality says the group gets $16,000 in royalties a year from Pandora off of about 44,000 daily plays. "Before Pandora we were a regional group. As soon as Pandora hit, we were being listened to around the country. That exposure has led to tens of thousands of record and single sales. It's incredible."

'Market Share Advantage'

Pandora's song selection process is built on the Music Genome Project, an elaborate algorithm that analyzes music and serves up personalized playlists. The database has more than a million songs from more than 100,000 artists, which have been vetted one track at a time. Each is categorized using up to 450 attributes or "genes," like gender of the lead vocalist or "Oom-Pah Feel" (for categorizing polkas).

Pandora users have created more than 5 billion personalized "stations" and given more than 30 billion thumbs-up/thumbs-down votes on recommended songs. That gives it an "unfair advantage" in providing the right music to happy listeners, says product chief Tom Conrad. "Apple's unfair advantage is that they get to be on the home screen. I'll take that fight."

The fight is definitely under way. Pandora's shares fell 10% in September after Apple said 11 million users tuned in to iTunes Radio in just its first five days. Itunes chief Eddy Cue has also said he wants to bring iTunes Radio to 100 countries. Pandora plays outside the U.S. only in New Zealand and Australia, partly because of the challenges in negotiating royalties country by country.

Still, Pandora has a "market share advantage," says NPD Group entertainment industry analyst Russ Crupnick. Apple in October said just 20 million users have listened to iTunes Radio. For now Pandora is striking the right notes with investors. It has ramped up its mobile and local ad sales efforts and signed key agreements with radio ad-buying services. Pandora also raised $523 million, before expenses, to fund acquisitions and new tech projects in a stock sale in September. And it's gained share in October, even with competition from Apple.

"The Web is playing all this music that's never been played on radio before. These are artists for whom it's found exposure and found money," says Westergren. "The solution for musicians is how do you make that number ten times as big. That's really what artists should focus on."

I've spent almost my entire career as a journalist covering tech in and around Silicon Valley, meeting entrepreneurs, executives and engineers, watching companies rise and fall (or in the case of Apple, rise, fall and rise again) and attending confabs and conferences. Befor...